Many economists predict an upcoming recession, and that future scenario brings with it interesting questions as it relates to multifamily investing. After the longest positive run in the history of market cycles, it’s smart for you, as an investor, to ask questions about current investment decisions. In this article, I will present a few of the most common questions and provide information that will help you make better decisions about your investments during this economic cycle.
HOW LONG DO RECESSIONS LAST?
There is no exact answer to this question because each recession is based on the mitigating factors of its time. On average, most recessions last two to three years. However, since the 1980s there have been only 5 recessions with the longest one in 2008 lasting 18 months.
THE RECESSION HAS BEEN COMING FOR YEARS, SO DO YOU STOP INVESTING FOR YEARS?
As extreme as that question may seem, you can bet that question crosses every investor’s mind at one time or another. The reality is that there are many variables and caveats that go into a decision about the right times to invest. However, here are some interesting facts designed to help you better understand.
POTENTIAL RECESSION BUFFERS
For example, let’s take a look at what Tendayi Kapfidze, Chief Economist at LendingTree suggests about this economic phase.
“Most discussions around a possible recession in 2020 center around a decline in government stimulus combined with a long expansion, suggesting the economy will need to rebalance,” he says. “It’s important to note that such a recession would not resemble the financial crisis-induced recession at the end of the last decade. It would likely be a milder downturn similar to that of 1990 – 1991 or 2001.”
Assuming that the upcoming recession follows the same patterns of the earlier recessions (1990 – 1991 and 2001), the result will most likely be a rebound in the refinance loan market. Furthermore, it’s interesting to note that currently, mortgage refinances are generally dropping while mortgage rates are rising.
He goes on to further explain…
“During those recessions, the 10-year treasury had peak-to-trough declines of 80 to 120 bps,” Kapfidze explains. “This is where it gets interesting for the mortgage industry. A rate decline would trigger a mini-refi boom that would address many of the challenges the industry currently faces due to the decline in refinance volume. Thus, the net result could actually be an increase in mortgage originations as happened in 2001.”
So, this scenario might be seen as a potential buffer for investors during the next recession. It’s also very encouraging to hear that the upcoming recession will not be as brutal as the last one. However, this all ties in with the four phases of the real estate cycle which I will explain in more detail further down in this article.
3 STEPS TO RECESSION-RESISTANT INVESTMENTS
Additionally, according to Ellie Perlman in Data Driven Investor, there are three steps to take to ensure that your investment is as recession-proof as possible:
- Instead of counting on properties with high appreciation, set your sites on properties with higher cash flow. An investment based on appreciation income is a losing deal when you need to sell it in a bad economy.
- Consider the worst case scenario when it comes to potential rent increases. Allowable rent increases are a big part of multifamily investing so be sure to check out the governmental cap on rent increases in the geographical area you wish to invest.
- Ask for the profit and loss statement that shows how well the property performed during the recession of 2008.
I’m suggesting a diversification strategy that adds multifamily. Some people hedge their investments in gold, stocks, and real estate…
WHAT DO YOU DO WITH THOSE STOCKS/IRAS THAT ARE GOING TO FALL OFF THE CLIFF?
I believe most people understand the importance of financial diversification. But, as we face the upcoming recession, diversification becomes more important than ever. One way to diversify is to invest in multifamily real estate syndications. During a time when stocks and IRAs lose their value, real estate often increases in value.
Moreover, when you invest in multifamily properties, it provides an inherent hedge again inflation. This is because as operating costs rise, multifamily syndications pass those costs on to the tenants by raising the rent. This is a good place to note the importance of the governmental caps on rent increases for the investment you’re considering.
HOW DO REAL ESTATE CYCLES AFFECT MY REAL ESTATE INVESTMENTS?
THE FOUR PHASES OF THE REAL ESTATE CYCLE
Real Estate investing is proven to be a cyclical market with four phases. The good news is there are strategies to successfully invest during any phase of the cycle.
- Recovery • In this phase, occupancies are at a low point with little demand. Rental rate growth is also negative or flat and may rise later in this phase but it will still be below the rate of inflation.
- Strategies include opportunistic, value-add, and core property investments.
- Expansion • The market goes up during this phase with a growing demand for rentals. The rate of occupancy improves and rents rise. Construction and development are rising or returning to normal levels.
- Strategies include development, core-plus, value-add, and opportunistic investments.
- Hyper Supply • During the expansion phase, supply sometimes tips the scales over demand. This might be caused by a sudden economic downswing that results in lower demand. Or, It might be a result of overbuilding. Never-the-less, rental vacancies rise when hyper supply happens. However, rental growth is still increasing, but at a slower pace.
- Strategies include core and opportunistic investments.
- Recession • During a recession, supply is greater than demand, thus there are higher vacancies. Additionally, income from rent reaches negative or below the rate of inflation levels.
- Strategies include opportunistic.
Moreover, there are several mitigating factors that affect the peaking and falling of a cycle. Those factors include:
- The way your investment strategy pairs with a particular phase.
- All possible exit strategies and the requirements of holding periods.
- What the investor expects for the returns.
- Timing is important for capital improvements.
I recommend that you continue to study the variances of these cycles to ensure you have a thorough working knowledge of how to invest effectively during all phases.
WHAT IS “VALUE ADD” INVESTING AND WHY IS IT THE WAY TO GO?
These are the type of properties that you invest in knowing that there will problems. However, these are issues that you are confident you can improve. Your expectation is that these improvements will improve cash flow, thus raising the value of the property and your return on investment (ROI).
So, if you want a lower-risk and predictable investment, a multifamily value-add investment is the way to go. There are many types of value-add options to consider when shopping for your multifamily investments. A few value-add strategies to consider include the renovation of older complexes, additional amenities, or upgraded landscaping.
Of course, the goal is that the improvements to the property support an increase in rent that gives you a higher return on your investment. However, you must factor in that most upgrades take a few years to complete throughout a complex. Because it is a gradual process, the investor is able to test the improvements and if they are favorable improvements that bring in higher rents.
WHY IS CONSERVATIVE UNDERWRITING A KEY TO SUCCESS?
Conservative underwriting only makes good sense with an ensuing recession. Lenders want to stay in business as well as investors and conservative underwriting is a good way to do that. To help you understand what that looks like, there are specific strategies to consider. Tip of the hat to Four Ways We’re Staying Conservative In Our Underwriting.
- Annual increases in rent and expenses. The consistent rent increases in the last 6 years will not continue forever. To compensate, conservative underwriting is projected at 2% to 2.5% annual rent growth. Underwriting for expense growth is also projected at a 2% annual increase.
- Increases in property taxes. Conservative underwriting will assume a safe route with 90% to 92% of the purchase price.
- Hikes in Interest Rates. Lenders will underwrite at higher rates and know which debt products are the best at this current time. They will also adjust for higher rates than they are quoted.
- Increase of Cap Rates. In many markets today, commercial real estate capitalization (cap) rates have trended lower, but they will likely increase during a recession. As such, conservative underwriting assumes an exit cap rate increase of 50 basis points.
Conservative underwriting allows better prospects of long-term return on investment and is especially important with an impending recession.
IS NOW A GOOD TIME TO LOCK IN FIXED 7 – 10-YEAR DEBT?
The answer is a resounding yes! With the lowest multifamily loan rates since 1997, now is a fantastic time to lock in fixed 7 to 10-year loans. More importantly, it is not a good idea to have to refinance or sell during a recession because as cap rates increase and occupancy rates decrease (lower NOI), property values decrease. As such, the results could be less than stellar. The best strategy is to ride out the recession.
CONTACT ME WITH YOUR QUESTIONS!
Please leave your comments or questions about the upcoming recessions risks. I am available to answer your questions or go over any additional information you may require. Feel free to contact me anytime!